Sometimes businesses get into trouble and unintentionally find themselves in liquidity traps. Liquidity traps come in a variety of shapes, sizes, and forms and, to a certain extent, result from business or industry-specific factors. However, when the liquidity traps are viewed from a generalized perspective, the primary sources [of liquidity traps] are centered in one of three areas, described in more detail in this post. Enjoy!
The volume and complexity of liquidity traps are extensive and vary from business to business. You’d be amazed at how many liquidity traps there are and how quickly they can consume your business. One day everything is fine, and then 180 days later, the markets turned, new product releases have been delayed, sales have softened, and the banks are all over you. To be quite honest, it’s not a matter of if you will have to manage a liquidity trap but rather when, so the better prepared you are in dealing with liquidity traps [and understand the primary causes of the liquidity traps], the better you’ll be at managing the problem. Are you still with me? Read on…
Having access to capital [whether debt or equity] represents one of the most important elements of executing a business plan. This point especially holds true when a business is turning the corner and is ready to grow rapidly because that’s when the demand for capital will be the greatest. As one of our business mentors constantly reminds us, “I don’t need access to capital going into a recession or downturn but I sure as the hell need access to capital as I come out of a recession and begin to grow quickly again”. Not managing liquidity traps and positioning a business to pursue new market opportunities often leads to one of the largest losses a company will ever realize [but never see]: lost market opportunity!
Next, the main course; here are the three primary sources area of the liquidity traps. Let’s move on…
Liquidity Trap Area#1: Asset Investment
As everyone knows, a company needs assets so that it can execute its business plan and generate revenue. Some assets are highly liquid and represent attractive vehicles on which to secure financing [think trade accounts receivables that a bank may use as collateral to extend a loan, new equipment that a leasing company may use as collateral to provide a long-term lease, and so on].
Other assets, however, such as certain inventory, prepaid expenses, intangible assets, and the like, aren’t nearly as attractive to a lender because the lender can’t liquidate the asset [and repay the loan] if the company can’t survive. The more liquidation value the asset has, the more likely lenders will provide financing.
The following list of asset investment liquidity traps are examples of when “Good Assets Go Bad”:
Trade receivables, in general, are usually very liquid assets that can be utilized to secure financing. Certain trade receivables, however, aren’t as attractive to financing sources. For example: trade receivables that are 90 days past due will often be excluded by a lender from being able to borrow against because the age of the receivable “indicates” that the business is having trouble paying its bills. While this situation may or may not be the case, the lender usually assumes the worst and excludes the trade receivable from being able to borrow against.
In addition to old trade account receivables, other receivables can create problems, including receivables generated from foreign customers, governmental entities, and related parties/entities. Also [and as strange as it may sound], receivable concentration issues may produce problems; if too much of your company’s trade receivables are centered in too few accounts, again the lender will get nervous [as its logic is now that if one big customer tanks, the entire company may go down].
Make sure that you have a complete understanding of what comprises your trade accounts receivable balance to have a clear understanding of what is available to borrow against at any point in time. While the balance sheet may state that your company has $1,000,000 [which the company can borrow 80 percent of, or $800,000], you may find that $400,000 of the receivables are “ineligible” — the receivables can’t be borrowed against — which leaves only $600,000 of good receivables to borrow against [meaning only $480,000 of financing is available].
Similar to trade accounts receivables, inventory can often represent the basis of a sound asset on which to secure financing; if you already have a readily available market for a company’s product, you should have no problem liquidating the products in case the worst should happen, right? No!
Financing sources tend to be very nervous and skittish with lending against inventory because if the worst should happen, all kinds of problems are produced by taking possession of the inventory and then attempting to sell or liquidate it. Financing sources aren’t prepared to handle this function. When all potential liquidation factors are considered with inventory, including identifying and disposing of obsolete inventory, paying a liquidator to sell the inventory, watching the market hammer the value of the inventory as it becomes available [for example, the going-out-of-business sale], the lender will be lucky to receive 40 to 50 percent on the dollar. Hence, lenders tend to shy away from extending loans against inventory, and when they do, lending rates are usually well below 50 percent.
Excessive inventory levels can create problems on numerous fronts:
- First, for every dollar of inventory increase, a lending source may only provide 40 percent of the cash necessary to support the added investment [leaving 60 percent to be supported by internal resources].
- Second, the risk of inventory obsolescence increases; the slower the inventory moves, the older it becomes, which generally forces the company into taking inventory write-off “hits” on the financial statements. As most business owners know, in today’s rapidly changing market, inventory can become obsolete in as little as three months; and
- Third, excessive inventory is expensive to maintain because it must be stored, insured, tracked, protected from theft, and so on. Quite often, inventory maintenance expenses can run up to 10 percent of the inventory’s cost on an annual basis.
Property, Equipment, and Other Fixed Assets:
The concept of consuming liquidity in fixed assets is based on the same concept as when you purchase a new car [but even worse]. That is, the day you purchase a new car and drive it off the lot, the car loses 25 percent of its value. For fixed assets, this concept also applies, but tends to be even more severe.
Once new equipment, computers, furniture, fixtures, and so on are purchased, within 90 days, their value is now based on a “used” status [and you will be lucky to get 50 percent on the dollar]. Compounding this problem is that if you do need to secure financing against the fixed assets [which are now used], the financing will be expensive [meaning higher interest rates] compared to acquiring the fixed assets when new.
The time to obtain financing with fixed assets is at the point of purchase when the asset value is the highest and the most financing sources are available to obtain competitive pricing and terms. Once the equipment becomes used, the market for financing sources becomes much more expensive, with far fewer choices available.
Liquidity Trap Area#2: Inappropriate Use of Debt
The second major liquidity trap is centered in not keeping your balance sheet in balance. By not keeping your balance sheet in balance, I mean that short-term debt, such as a line of credit structured to support trade accounts receivables, is utilized to finance a purchase of a long-term asset. This scenario can create significant problems for a company.
Say that a company has structured a line of credit financing agreement or loan where it could borrow up to 80 percent of eligible or qualified receivables. The company is growing quickly and had increased its trade accounts receivables to roughly $2 million in total, of which 90 percent were eligible to borrow against. In total, the company borrowed $1.4 million, which was within the financing agreements limit [$2 million of total account receivables of which $200,000 where ineligible to borrow against leaving a net borrowing base balance of $1.8 million producing a total borrowing capacity of $1.44 million]. Of the $1.4 million, $400,000 was used to purchase fixed assets and $1 million used to support the trade accounts receivables. Within six months, the company’s trade accounts receivable decreased to $1.5 million while at the same time the ineligible percent increased to 20 percent [as a result of certain trade accounts receivables becoming 90 days past due]. The change in accounts receivables reduced the company’s ability to borrow to $960,000 [$1.5 million of trade accounts receivables times 80 percent eligible times 80 percent advance rate]. Unfortunately, the company used the cash generated from the $500,000 decrease in trade accounts receivables to reduce trade payables and cover operating losses [as well as pay down the loan]. The company was able to pay down the loan only by $200,000, leaving an outstanding balance of $1.2 million against a borrowing available of $960,000. Needless to say, the financing source requested the company “cure” this over-advanced position, which the company couldn’t [leading to a very interesting round of discussions and additional financing source restrictions being placed on the company]. By not properly financing the fixed asset purchase [which the financing source should little sympathy in addressing, especially given the losses the company had recently incurred], the company fell into a very common and painful liquidity trap.
The exact opposite can happen as well. For example, say that a loan payable, which has a repayment term of three years, is used to support a current asset [such as trade accounts receivables]. While the asset [or trade accounts receivable] may be growing as a result of increased sales, the debt is being reduced over a three-year period. Just when the company needs capital to finance growth, capital is flowing out of the organization to repay debt.
It’s imperative that a proper balance of capital to asset type is maintained to better manage the balance sheet. The following three simple rules can help you match capital or financing sources with asset investments:
- Finance current assets with current debt. Current assets, such as trade accounts receivable or inventory, should be financed with current debt, such as trade vendors or suppliers and a properly structured lending facility.
- Finance long-term assets with long-term debt. Fixed assets, such as equipment, furniture, computers, technology, and so on, should be financed with longer term debt, such as term notes payables [a five-year repayment period], operating or capital leases, and so. The general concept here is that a fixed asset will produce earnings or cash flow over a period of greater than one year, and as such, the cash flow stream should be matched with the financing stream.
- Debt-financing sources provide capital for tangible assets and don’t like to finance losses or “soft” assets. Other asset types [including intangibles such as patents or trademarks, certain investments, and prepaid expenses] and company net losses need to be supported from equity capital sources including the internal earnings of the company.
Liquidity Trap Area#3: Excessive Growth Rates
The most common, but least understood liquidity trap is when your business experiences excessive growth rates. A rapidly growing business requires significant amounts of capital to support ongoing operations. As revenue [and hopefully profitability] levels grow, so will assets and the need to finance the assets. The problems rapidly growing companies run into is that they get caught up in the fact that new market opportunities seem almost endless and, as such, the company “invests” earnings from profitable operations into the expansion of new operations [which tend to lose money during the startup phase].
This strategy, if properly managed, can be very effective as long as management keeps a keen eye on the distribution of earnings between supporting new operations versus strengthening the balance sheet. While no set rule dictates how much of your earnings should be used to reinvest in new operations versus strengthening the balance sheet, the real key lies in the ability to keep your debt-to-equity ratio manageable so that if the company does hit a speed bump, resources are available through the difficult times.
Pushing your company to the limit by leveraging every asset with debt financing and reinvesting internal earnings in new operations is a recipe for failure! Businesses must constantly manage the growth versus available capital tradeoff issue to ensure that their interests aren’t exposed to unnecessary risks that quite often carry extremely expensive outcomes.